In the past week, GameStop (NYSE:GME) stock’s 215% rise has triggered an uneasy sense of déjà vu. The company’s legions of Reddit fans are bullish as ever, but recent memories of GME’s steep fall continue to haunt investors. With GME stock back at $130, is it time to buy or sell?
In a world where investors often demand straightforward yes/no answers, GameStop’s value is maddeningly uncertain. On one hand, the firm’s retail business remains in full decline, making its shares worth less than $40 when calculated from a cash flow perspective. But on the other, the firm sits in an immense gaming industry that earns more than the global movie and U.S. sports industries combined. In other words, Ryan Cohen and other activist investors could still push GameStop back to $500 in the long term.
Investors rarely have a chance to invest in a turnaround as stark as GameStop. So, for those who still love the stock, here’s whether to buy or sell.
GME Stock: The Bull Case
In August 2020, Chewy (NYSE:CHWY) co-founder Ryan Cohen bought 9 million shares of GameStop. His promise to help the flagging firm “evolve into a technology-driven sector leader” sent GME stock soaring.
Short squeezes, trading bots and Reddit fans aside, the price bump had fundamentally sound drivers. At $4/share last summer, GameStop was worth just $280 million, or less than the cash on its books. Even Benjamin Graham’s “net-net” investors might have considered buying in. The company has since embarked on a nascent turnaround, forcing out its longtime CFO and installing Ryan Cohen and two associates on its board. While the firm still has a long way to go, it’s certainly a good start.
GameStop couldn’t have chosen a better time for a change. The coronavirus pandemic sent the video game industry on an unimaginable growth spurt. Revenues in 2020 grew 20% from the year before as people turned their attention (and wallets) to home-based pursuits.
Valuations in the gaming sector have also reached new peaks. Roblox, a user-generated game platform, is slated to go public at a $29.5 billion valuation – a 30x price-to-sales multiple. Unity Software (NYSE:U), another freshly IPO’ed video game maker, is worth a similar figure. As GameStop turns its attention towards tech-driven businesses, the firm could see a resurgence in its brand.
But most importantly, the firm’s newfound vigor from both Reddit fans and the board could send the firm to a $500/share price. The video game retailer’s inflated stock price makes secondary offerings possible. And besides, no turnaround is ever impossible until the bankers start calling in the loans.
The Bear Case – Valuation
GameStop’s bull case, however, relies on investor optimism. Today, the firm is still burning through ~150 million cash per year despite wringing out as much revenues from existing stores. Revenues will only continue to decline as cuts in its retail locations start to show up on its financial statements. The broader shift to digital-only consoles will also further cut into the firm’s once lucrative used-game sales.
GameStop also has a debt problem. After a decade of aggressive share buy-backs and dividend payments, the company’s leverage ratio now sits at a 3.5x D/E — four times higher than comparable companies. Adding its operating lease obligations, that means GameStop only has a 2–3-year window to turn around, despite its oversized cash hoard.
Finally, the company will have trouble finding any reasonably-priced acquisitions. The firm had its chance back in 2011 when it bought Spawn Labs and Impulse — game streaming and distribution platform companies, respectively. But today, there’s little way to use GME’s 1.6x P/S shares to buy stock in software companies trading at >30x P/S.
That makes GameStop’s current $130 price seem unsustainable in the short run. Analysts expect the firm to generate $5.25 billion of revenues in 2021, so GameStop shares will likely slide back down in the medium term.
Should You Invest in GME Stock?
Investing in GameStop involves making a bet on a turnaround company. Long-term investors who like the stock could make enormous returns if things go well. VR, e-sports, mobile, and cloud gaming are all potential billion-dollar businesses.
But people who are in it for quick profits should look elsewhere. The turnaround will take multiple years, and GameStop’s recent run to $130 will likely prove temporary. Expect shares to drop back to the $40-60 range before potentially recovering on the turnaround.
Don’t feel pressured to double down on a company just for the sake of it. Because investing in GameStop needs more than hope. It requires an unyielding belief that Ryan Cohen and Reddit shareholders will one day turn the sinking video game retailer around.
On the date of publication, Tom Yeung did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing.